Instead, they see value in high-grade corporate and municipal bonds.
Short-term high-grade bonds are a favorite of See Yeng Quek, a managing director and chief investment officer for fixed income at Philadelphia-based Delaware Investments, a unit of Lincoln National Corp. of Radnor, Pa. Compared with Treasuries, such bonds offer an attractive yield at a good price, he said.
And it is a price at which investors are being fairly compensated.
High-yield bonds are cheaper, but given the economy, it may still be too early to jump into junk, Mr. Quek said.
SURVIVAL IS KEY
"You need to focus on issuers that can survive," he said.
In this market, that means focusing on high-quality, defensive names.
Bonds issued by companies in the consumer staples, utilities and health care sectors look particularly attractive, Mr. Quek said.
"You have to be able to survive this period without [the] need for financing," he said. "If you have to come to market right now, the price of refinancing will be costly."
Mark Beischel, a senior vice president of Waddell & Reed Investment Management Co. in Overland Park, Kan., agrees.
"Can [companies] continue as a going concern for the next two years without access to the capital markets?" he asked. "If they meet [those] criteria, then we would investigate to see if the bonds are worth the risk."
It is possible for companies whose bonds are junk to meet that criteria, said Mr. Beischel, co-manager of the $517 million Waddell & Reed Advisors Global Bond Fund (UNHHX) and $53 million Ivy Global Bond Fund (IVSAX), both advised by Waddell & Reed.
But at this point, that isn't very likely, which isn't surprising, given how much defaults are expected to rise.
The default rate for issuers of U.S. corporate junk bonds — those that New York-based Standard & Poor's rates BB+ and below — is expected to "catapult" to an all-time high of 13.9% by December, S&P said in a Jan. 22 report.
There is still an argument to be made, however, for buying high-yield bonds, said Martin Fridson, chief executive of Fridson Investment Advisors LLC and former head of high-yield strategy at Merrill Lynch & Co. Inc. Both firms are based in New York.
Default rates are going up, but in many cases, investors in high-yield bonds are getting compensated adequately for the extra risk, he said.
But that isn't a bet that James T. Swanson, an investment officer and chief investment strategist with MFS Investment Management of Boston, is willing to make just yet. He likes high-grade corporate bonds, but also thinks that muni bonds look particularly good.
"I get more bang for my buck from munis because the price discount is so huge," said Mr. Swanson, a manager of the $162 million MFS Diversified Income Fund (DIFAX).
In the case of muni bonds, a big discount doesn't mean increased risk.
TRADING AT DISCOUNTS
There are a variety of reasons that muni bonds are trading at discounts, said Philip G. Condon, head of municipal bond portfolio management at DWS Investments, a unit of Deutsche Asset Management Inc. of New York.
Deleveraging forced many hedge funds to flood the market with muni bonds. That and problems faced by muni bond insurers related to the subprime-mortgage crisis forced muni prices down, Mr. Condon said.
There is also headline risk associated with the news of muni budgets' being squeezed.
What most investors don't understand is that municipalities are required to balance their budgets, Mr. Condon said. That is one reason why muni bond defaults are very rare, he said.
High-grade corporate and muni bonds, however, aren't the only places where investment managers see value in the bond markets.
Bond guru Bill Gross, managing director at Pacific Investment Management Co. LLC of Newport Beach, Calif., has been banging the drum for months about investing in fixed-income securities that the government plans to buy.
"Pimco's view is simple: Shake hands with the government; make them your partner by acknowledging that their checkbook represents the largest and most potent source of buying power in 2009 and beyond," he wrote in his January outlook for investors.
In other words, buy what the government will buy, which includes investments such as agency-backed mortgages, bank preferred stocks and senior bank debt, Mr. Gross wrote.
Such a strategy makes sense on the surface, but there are issues about which investors need to be aware, Mr. Swanson said.
The government is trying to get mortgage rates to come down, which increases prepayment risk, or the risk associated with the unscheduled early return of principal, he said. And given the shape of the banking industry, "casualties" can be expected in the bank loan market, Mr. Swanson said. Senior bank debt, however, is trading at such de-pressed levels that investors may feel that they are being rewarded for the risk, he said.
Bank preferred stocks and senior bank debt are particularly attractive, said Gregory H. Makowski, a principal of CFS Investment Advisory Services LLC, a Totowa, N.J., firm with $500 million under management.
The investments are beaten down to the point where there is huge potential for appreciation, he said. That appreciation seems more likely than not, now that the government has taken a "major position" in a number of banks, Mr. Makowski said.
E-mail David Hoffman at dhoffman@investmentnews.com.
